How is Money Made from Investing?

There are 3 main mechanisms that need to be understood if we want to understand how value and wealth is created through investing.
They are: capital appreciation, income (dividends/distributions) and compounding.

#1: Capital Appreciation

If the price of a share/stock/asset rises (capital appreciation) – the value of that investment also rises by that same amount.
This can happen if the stock becomes more valuable through increased earnings/profits, supply and demand for that stock, positive news etc.
For ETFs – there is capital appreciation because the basket of companies inside it appreciates.

Case Example

Steven invests $1000 in a stock called CYN – it is valued at $1 a share. He now owns 1000 shares of CYN.
In 3 months time the stock price increases from $1 to $1.20.
The value of his investment is now $1.20 x 1000 shares = $1200.

He decides to sell his investment at this time- he has made $200 in capital appreciation in 3 months time.

#2: Income (dividends/distributions)

Dividends are paid from individual stocks – when a company earns a profit they can either reinvest it (to drive more capital appreciation) or reward its shareholders with this money.
This may act as an incentive for prospective investors to invest in that business – as they will expect a dividend.

Distributions are paid from ETFs – when an ETF receives dividends from the 200 companies inside it eg in the ASX 200 (top 200 companies in Australia) – it combines this all and pays it out to investors – usually quarterly.

#3: Compounding

“Compound interest is the 8th wonder of the world. He who understands it, earns it … he who doesn’t … pays it” – Albert Einstein

This is where the magic really happens – money does grow slowly at first but will grow increasingly faster later.

Case Example

Some maths behind this – If you invest $10,000 and it grows at 9% per year (historical return of the ASX 200 over the last 10 years).

In the 1st year, you’ll make $900 (9% x $10,000) and end with $10,900
In the 2nd year, you’ll make $981 (9% x $10,900) and end with $11,881
In the 3rd year, you’ll make $1069 (9% x $10,000) and end with $12,950
In the 10th year, you’ll make $2100 and end with approx $25,000.
In the 30th year, you’ll make $11,000 and end with approx $132,000

This compounding also works when ETFs offer a Dividend Reinvestment Plan (DRP).
When an ETF pays a distribution – the computer can use this distribution to buy more shares of ETFs. These shares will later pay dividends. You are now earning dividends on your dividends!

Summary

There are a few mechanisms that increase the value of your investments, especially when investing in an ETF. If your ETF tracks the Australian Market as a whole – historically it has returned 9% per year and this is made up of capital appreciation (4-5%) and dividends/distributions (3-5%). Compounded all these returns accelerates your portfolio over time and this is where investing earlier has larger benefits.